Systemic Risk

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“Capital Shortfall: A New Approach to Ranking and Regulating Systemic Risks,” by Professors Robert Engle, Viral Acharya, Matthew Richardson, American Economic Review Papers and Proceedings, (January 2012).ABSTRACT The most severe impacts of the financial crisis of 2007–2009 arose immediately after the failure of Lehman Brothers on September 15, 2008. It is natural to wonder whether the United States should have arranged for an orderly rescue of Lehman as it did for Fannie Mae and Freddie Mac the week before and as it did for AIG, Merrill Lynch, Citigroup, Bank of America, Morgan Stanley, Goldman Sachs, Washington Mutual, and Wachovia as well as many smaller and foreign banks over the next days and weeks. How much capital would have been necessary ex post to arrange such an orderly rescue? Another policy recommendation of the Dodd-Frank Act of 2010 is to facilitate orderly liquidation and/ or resolution and require living wills of financial institutions so that no future bailouts will be necessary. Will this work when we need it? There is, however, also a third choice. Rather than discuss whether to rescue or not, it is sensible to regulate ex ante financial institutions whose failure is likely to have major impacts on the financial and real sectors of the economy; for instance, regulate them to reduce their risk, and consequently the probability that taxpayers will face this choice.

Papers

ABSTRACT (Click Here for Paper) The most severe impacts of the financial crisis of 2007-2009 arose immediately after the failure of Lehman Brothers on September 15, 2008. It is natural to wonder whether the United States should have arranged for an orderly rescue of Lehman as it did for Fannie Mae and Freddie Mac the week before and as it did for AIG, Merrill Lynch, Citigroup, Bank of America, Morgan Stanley, Goldman Sachs, Washington Mutual, and Wachovia as well as many smaller and foreign banks over the next days and weeks. How much capital would have been necessary ex post to arrange such an orderly rescue? Another policy recommendation of the Dodd-Frank Act of 2010 is to facilitate orderly liquidation and/ or resolution and require living wills of financial institutions so that no future bailouts will be necessary. Will this work when we need it? There is, however, also a third choice. Rather than discuss whether to rescue or not, it is sensible to regulate ex ante financial institutions whose failure is likely to have major impacts on the financial and real sectors of the economy; for instance, regulate them to reduce their risk, and consequently the probability that taxpayers will face this choice.

ABSTRACT (Click Here for Paper) There is a growing view that systemic risk arises due to loss of intermediation for the overall economy - a negative externality - when the financial sector becomes under-capitalized as a whole. In turn, the systemic risk contribution of an individual financial firm can be defined as its share of this negative externality. Motivated by this intuition, a number of authors have proposed a “Pigovian tax” that would charge each firm in relation to its marginal potential impact on the aggregate risk of the financial sector. This paper discusses and analyzes several measurement strategies that could be used to estimate such systemic risk surcharges. Some empirical evidence is provided which shows how these measurements line up with the loss of capitalization of financial firms during the financial crisis of 2007-2009.

ABSTRACT (Click Here for Paper)
Systemic crises tend to erupt when highly leveraged financial institutions are forced to deleverage, sending the economy into recession; leverage is a central element of economic cycles and systemic risk. While traditionally the interest rate has been regarded as the single key feature of a loan, we argue that leverage is in fact a more important measure of systemic risk. We discuss how leverage can be monitored for assets, institutions, and individuals, and highlight the benefits of monitoring leverage. Our main conclusions are:
Monitoring leverage is “easy”: Leverage at the asset level can be monitored by recording margin requirements, or, equivalently, loan‐to‐value ratios. This provides a model‐free measure that can be directly observed, in contrast to other measures of systemic risk that require complex estimation.
1)Monitoring leverage is monitoring systemic risk
2)Liquidity crisis management
3)New vs. old leverage

ABSTRACT (Click Here for Paper) Systemic risk can be broadly thought of as the failure of a significant part of the financial sector one large institution or many smaller ones leading to a reduction in credit availability that has the potential to adversely affect the real economy. Given the interconnectedness of the modern financial sector, and for the purposes of systemic regulation, one should think of a “financial firm” as not just the commercial bank taking deposits and making loans, but also include investment banks, money-market funds, insurance firms, and potentially even hedge funds and private equity funds.2 There are several types of systemic risk that can be generated from the failure of a financial institution, and especially so during a financial crisis, such as counterparty risk, spillover risk due to forced asset sales, increased cost of inter-bank borrowing, and the risk of “runs” on the shadow banking system.

ABSTRACT (Click Here Paper) There are four pillars of effective regulatory architecture that are common across all financial systems. Good architecture should (1) encourage innovation and efficiency, (2) provide transparency, (3) ensure safety and soundness, and (4) promote competitiveness in global markets. Efforts to pursue these objectives at the same time inevitably create difficult policy trade-offs. Measures that assure greater financial robustness may make financial intermediation less efficient or innovative, for example. Efforts to promote financial innovation may erode transparency, safety, and soundness. Competitive pressure among financial centers may trigger a race to the bottom in terms of systemic robustness to internal and external shocks. Unfortunately, benchmarks underlying the financial architecture, on which it is easy to find agreement, are far more difficult to define in detail and even more difficult to calibrate in practice. We know that excessive regulation involves costs, but what are they? We also know that under regulation can unleash disaster, which can be observed only after the fact. So optimum regulation is the art of balancing the immeasurable against the unknowable. It is not surprising that financial crises are a recurrent phenomenon. In this chapter we spell out the practical alternatives for financial regulation and identify the nature of their impact on key attributes of financial products, markets, and firms. We then narrow the range of regulatory options to those contained in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and comparable regulatory initiatives around the world, and assess them in light of the four pillars of regulatory architecture underlying a financial system that successfully serves the public interest.

ABSTRACT (Click Here for Paper) We present a simple model of systemic risk and we show that each financial institution's contribution to systemic risk can be measured as its systemic expected shortfall (SES), i.e., its propensity to be under capitalized when the system as a whole is under capitalized. SES increases with the institution's leverage and with its expected loss in the tail of the system's loss distribution. Institutions internalize their externality if they are taxed based on their SES. We demonstrate empirically the ability of SES to predict emerging risks during the financial crisis of 2007-2009, in particular, (i) the outcome of stress tests performed by regulators; (ii) the decline in equity valuations of large financial firms in the crisis; and, (iii) the widening of their credit default swap spreads.